PowerPoint® Slides by Ron Cronovich

CHAPTER

11

Aggregate Demand II:

Applying the IS-LM Model

© 2010 Worth Publishers, all rights reserved

SEVENTH EDITION

MACROECONOMICS

Context

Chapter 9 introduced the model of aggregate demand and supply.

Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve.

CHAPTER 11

Aggregate Demand II

2

In this chapter, you will learn:

how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy how to derive the aggregate demand curve from the IS-LM model

several theories about what caused the

Great Depression

CHAPTER 11

Aggregate Demand II

3

Equilibrium in the IS -LM model

The IS curve represents equilibrium in the goods market. r

LM

Y C (Y T ) I (r ) G

The LM curve represents money market equilibrium.

r1

M P L(r ,Y )

Y1

The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets.

CHAPTER 11

Aggregate Demand II

IS

Y

4

Policy analysis with the IS -LM model

Y C (Y T ) I (r ) G

r

LM

M P L(r ,Y )

We can use the IS-LM model to analyze the r1 effects of

fiscal policy: G and/or T

monetary policy: M

CHAPTER 11

Aggregate Demand II

IS

Y1

Y

5

An increase in government purchases 1. IS curve shifts right

1

by

G

1 MPC causing output & income to rise.

2. This raises money demand, causing the interest rate to rise…

r

LM

2.

r2 r1 3. …which reduces investment, so the final increase in Y

1

is smaller than

G

1 MPC

CHAPTER 11

Aggregate Demand II

1.

IS2

IS1

Y1 Y2

Y

3.

6

A tax cut

Consumers save r (1MPC) of the tax cut, so the initial boost in spending is smaller for T r than for an equal G…

2.

r21 and the IS curve shifts by

1.

LM

1.

MPC

T

1 MPC

2. …so the effects on r

and Y are smaller for T than for an equal G.

CHAPTER 11

Aggregate Demand II

IS2

IS1

Y1 Y2

Y

2.

7

Monetary policy: An increase in M

1. M > 0 shifts the LM curve down

(or to the right)

2. …causing the interest rate to fall

3. …which increases investment, causing output & income to rise. CHAPTER 11

Aggregate Demand II

r

LM1

LM2

r1 r2 IS

Y1 Y2

Y

8

Interaction between monetary & fiscal policy

Model:

Monetary & fiscal policy variables

(M, G, and T ) are exogenous.

Real world:

Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.

Such interaction may alter the impact of the original policy change.

CHAPTER 11

Aggregate Demand II

9

The Fed’s response to G > 0

Suppose Congress increases G.

Possible Fed responses:

1. hold M constant

2. hold r constant

3. hold Y constant

In each case, the effects of the G are different…

CHAPTER 11

Aggregate Demand II

10

Response 1:

Hold M constant

If Congress raises G, the IS curve shifts right.

r

LM

1

If Fed holds M constant, then LM curve doesn’t shift. r2 r1 IS2

IS1

Results:

Y Y2 Y1

Y1 Y2

Y

r r2 r1

CHAPTER 11

Aggregate Demand II

11

Response 2:

Hold r constant

If Congress raises G, the IS curve shifts right.

r

LM

1

To keep r constant,

Fed increases M to shift LM curve right.

2

r2 r1 IS2

IS1

Results:

Y Y3 Y1

LM

Y1 Y2 Y3

Y

r 0

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Aggregate Demand II

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Response 3:

Hold Y constant

If Congress raises G, the IS curve shifts right.

To keep Y constant,

Fed reduces M to shift LM curve left.

LM

2

LM

r

1

r3 r2 r1

IS2

IS1

Results:

Y 0

Y1 Y2

Y

r r3 r1

CHAPTER 11

Aggregate Demand II

13

Estimates of fiscal policy multipliers from the DRI macroeconometric model

Assumption about monetary policy

Estimated value of

Y / G

Estimated value of

Y / T

Fed holds money supply constant

0.60

0.26

Fed holds nominal interest rate constant

1.93

1.19

CHAPTER 11

Aggregate Demand II

14

Shocks in the IS -LM model

IS shocks: exogenous changes in the demand for goods & services.

Examples:

stock market boom or crash

change in households’ wealth

C

change in business